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The long recession and sluggish recovery have left many Americans without much of a safety net for their finances. Unfortunately, many of the employers that workers depend on for their retirement pensions are facing problems of their own in funding their pension plans.
With Social Security facing increasing pressure and personal savings at relatively low levels, any threat to pensions for older workers and retirees could have dire consequences. Yet surprisingly, investors have largely ignored pension-plan problems despite the impact they could have on earnings and long-term prospects. Let's take a closer look at the extent of the problem and how investors should plan for it.
What's the big deal?
Pension plans hold assets that companies intend to use to provide benefits for their workers after they retire. Just as you have to set aside money regularly to save and invest for your own financial future, companies must set aside a certain amount of assets each year to cover future pension liabilities.
But pension accounting rules are flexible enough that companies aren't consistent about how they account for their required pension contributions. A report from Gradient recently cited in Barron's highlighted six stocks that stood out as being somewhat aggressive with their pension accounting practices, potentially leading to their financial statements being somewhat misleading.
Perhaps the key problem facing pension plans is the need to earn healthy returns on their investment assets. For Allegheny Technologies (NYSE: ATI ) and Potlatch (NYSE: PCH ) , assumptions that the plan will be able to earn 8.5% on their assets seem optimistic, given extremely low interest rates on bonds and the tepid returns from the stock market for more than a decade. Forest-products giant Weyerhaeuser (NYSE: WY ) goes a step further, setting a 9% expected rate of return. The higher the rate used, the less a company has to save now in order to comply with funding requirements. But there's little reason to believe that one company's better positioned to earn stronger returns on pension assets than other companies.
Moreover, another sign of stress has to do with changes to return assumptions. R.R. Donnelley & Sons (Nasdaq: RRD ) raised its estimated rate of return from 8.3% to 8.4% in 2011, even though the actual performance of its investment portfolio was poor. Many such companies appear to be counting on reversions to the mean in returns to bail them out after the Lost Decade left them short of expectations.
Lofty return assumptions aren't the only way a pension plan can get into trouble, though. Gradient points to Northrop Grumman as an example of a company using a discount rate that lets it produce lower estimates of future pension obligations. Any mistake in that vein could lead to similar underfunding even when the plans look fine under normal accounting guidelines.
Meanwhile, with Consolidated Edison, utility-specific practices allow the company to treat actuarial losses as assets on financials. That could cause problems for investors more used to practices in other sectors.
Much ado about nothing?
You might expect that these companies' shares would take a hit from this news. Yet investors don't seem particularly worried. In the weeks since the Gradient report came out, Weyerhaeuser, Northrop, and Con Ed have raced to 52-week highs, while Potlatch and R.R. Donnelley have bounced off lows.
Why aren't investors more worried? With such a focus on the short run, investors can hope that companies will be able to put off any costly charges to earnings until well into the future. Recent accounting rule changes support that kick-the-can mentality, and in a slow growth environment, few companies want to risk taking big charges to boost their funding levels if they don't have to.
Eventually, these companies may follow the lead of Ford (NYSE: F ) and General Motors by offering to buy workers out with lump-sum pension payments. By taking big one-time charges, they may convince investors to downplay these costs, having less of an impact than making bigger contributions and hitting earnings every quarter. Smart investors need to watch out for such moves and understand that no matter when a company recognizes its liabilities, pension obligations are lingering out there and in many cases are becoming an increasingly large future threat.
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